Over the past few years, I’ve built and bought a range of small businesses, both offline and off. What I’ve discovered is that most entrepreneurs have no idea how to value their business. Not only does this make it hard to sell a business, it makes it hard to grow a business. And naming hilariously wrong prices is a good way to scare off buyers, who will rightly consider you a bit of a fool.
Why is this? Because if you don’t know how a business is valued and why you are likely to focus on all the wrong things. The smart money that buys businesses knows what’s important and what isn’t. By focusing on the value of the business, you will naturally put your hard work to good use.
The following applies strictly to small businesses, not VC funded grabs at billions — that works entirely differently.
The easiest way to value a small business is expected future profits. Expected profits look like past profits. If you have a business that made 100k in profit this last year, and 50k last year, and 30k the year before that, then it’s safe to assume that the next year you might make between 100–200k profit because of the extreme growth. For small businesses, the usual value is 1–2x future earnings, but for some industries this is different. There’s a simple price ceiling: if someone could stick the money in treasury bills, the stock market, or something more “hands-off”, how much would they make per year? If it’s more than they get for your business, then your price is way too high.
What if your company isn’t profitable? First the bad news: a business that isn’t profitable isn’t worth much if anything. Buying a money loser means buying a problem. There are exceptions though.
Part of this calculation will also include gross margins. High margins for an industry are very very good and can command a STRONG premium. High margins are usually a result of some of the factors discussed below.
Be prepared and know your numbers inside and out around cash flow, overhead, gross and net margins, and growth metrics. If you don’t know these things as an owner, that’s BAD.
Let’s say your business is growing quickly but isn’t yet profitable. This is still interesting to a purchaser. One way of looking at the business is the replacement cost: the cost it would take to replace the equipment, find a comparable location, etc. That’s used prices, not brand new. Compare this amount to the cost of buying a profitable business in the same industry. If the replacement cost is higher than the cost of buying a comparable business, then the obviously the purchaser would just go buy a profitable business.
The value of a profitable or break-even business becomes the price CEILING, unless you truly have some secret magical thing that means your business will dominate. But if so, why are you selling? It’s unlikely that any buyer will believe that a business for sale has such an advantage yet isn’t profitable.
Buyers like high replacement cost values because it puts a floor on their risk. If things went south, it tells them what they could get for selling the business “for parts”.
One adjustment to all of the above is growth. Not just the growth of your business, but growth of the industry. If your industry is growing 10% a year but your business is growing 5% a year, that’s BAD. Despite having a growing business, you are falling behind your rivals. This increases risk for the buyer and drops the value they will offer.
Similarly, if you are growing 20% a year in a market that’s growing 5% a year, that’s great. It makes your business vastly more valuable to potential buyers. This is true even if your company isn’t yet profitable — as long as you can show a clear path to profitability.
There are lots of companies that grew and then collapsed. Why? Lack of competitive advantage. Eventually, someone with deep pockets came in and bought market share until they won. If your business has powerful structural advantages — a critical location, patents, dominant search rankings, or similar, then that creates a barrier for new entrants.
Strong competitive advantages raise the value of your business. Claiming you have strong advantages that are crap lowers the value of your business. Protip: don’t claim a bunch of advantages that are BS, it insults the buyer or makes you look like an idiot.
Some brands appeal to high-dollar customers with exclusivity. Others appeal to the masses with valuable goods. Both models can work and both can scale. What’s most important is that you have a powerful and well-defined brand that works and doesn’t box in the business.
Exclusive is good, but too exclusive means you can’t grow. Value is good, but cheap products mean low margins, which makes scaling less efficient.
For small businesses, a rule of thumb is 1–3x yearly profits as a baseline. If your business isn’t profitable, it’s not worth much. Nobody other than you cares how much you spent getting there. That’s your problem, not the buyers.
NEVER mention how much you invested in the business. If it’s a tiny amount, the buyer will wonder why they should buy instead of build. If it’s a large amount, then the buyer has to wonder if you’re a fool or if there are issues driving unusual costs. In short, talking about what you invested in the business is the mark of someone who doesn’t understand the conversation and can only hurt you. Talk about operating costs, cash flow, margins, and growth. That’s what matters.